I was asked an interesting question the other week, with regards to what is an expense. A friend is trying to put together her yearly accounts for a small sole proprietorship and is wondering what she can expense and what she can’t expense.
There are many books and websites out there which will give a very technical set of responses. But at its simplest form – an expense is the cost of doing business.
But the cost of doing business is not necessarily an expense. An expense is a cost for a good or service which is used up within a 12 month period – be it stationary, a one year computer maintenance contract, or rent. The other type of “cost of doing business” is an asset.
Assets come basically in two forms – current assets and long term assets. Generally speaking, when putting together your Balance Sheet you list your assets in the order of liquidity – how fast that asset can be converted into cash. If you live in North America the basic presentation is:
Future Income Tax Asset – ST
Short Term Investments (usually a term deposit with a bank)
Future Income Tax Asset – LT
Goodwill (this no longer exists in Canada, though it has been grandfathered in and can remain on the books, but cannot be depreciated)
Basically an asset is something that is acquired to help in the generating of income for the business – working premises, machinery, cash to pay the bills etc.
When purchasing goods and or services for a business not all purchases are allowable business expenses/assets. The company/individual must pay attention to the nature of their business. Purchasing yacht is not a business cost if your business is a hair dressers. Acquired assets have to make sense to stakeholders – be they shareholders, bondholders, creditors, HMRC, customer.
Can I purchase a house and expense it? No. Not unless you happen to be involved in real estate, then that house is inventory stock and the cost of that house is only written off when that house is resold:
1. Purchase House for £100
a. Debit Inventory 100
b. Credit Cash (100)
2. House resold for £125
a. Credit Income (125)
b. Debit Cash 125
c. Credit Inventory (100)
d. Debit Cost of Sales 100
e. Gross Margin/Profit (25)
If you aren’t in the business of real estate purchasing a house would make it a Fixed Asset and put it directly on the balance sheet. You can then write off a portion over a number of years (40yrs). But, and this is major – that house better be used for business only. The moment it is used for anything else is no longer a business asset. So my friend the hairdresser could run her business from her house, but the house itself is not a business cost. She can write off a portion of the cost of running that house – utilities (gas, electricity, water, council tax), telecom costs and if there is a mortgage a portion of the interest paid on that mortgage. So if Siobhan used company monies to purchase that house she wants, then that is a Director’s Drawing – which means she owes money to the company. The company’s money may be used to purchase that house, but the company does not own that house – the director, Siobhan, does. She needs to repay the funds to the company. And Director Drawings are not an expense, but a reduction in accumulated Retained Earnings.
So if my friend Siobhan wants to continue with her business and not have any trouble with her stakeholders, she needs to pay attention to a few things, and ask herself:
1. This good or service I am paying for – will it last longer than a year? If less than a year, expense, if more than a year then it’s an asset
2. This good or service I am paying for, does it related towards the cost of doing business? If it isn’t related then it is not a business cost but instead a personal expense which the company is paying for – it must be repaid to the business
3. And most importantly – Siobhan needs to keep her bank accounts separate – one for business, and one for personal use, that way it’s easier to account for incomes and costs